Cannabis Watch: The weed middleman that expects to make billions as the Sunkist of pot

In the illegal drug business, there is a lot of money and safety in wholesaling — being a middleman instead of producing drugs or selling them on the street. As marijuana finds legitimacy, it may end up producing the same kind of system, judging by a California company that has emerged as a powerful distributor with revenue totals that rival some of the largest pot companies.

For many of the world’s biggest cannabis businesses, the only viable option to capture enough of Canada’s legal recreational market is to grow their own marijuana, an operation many say they would prefer not to undertake. But in California, where state lawmakers have allowed a slow process of moving an estimated 68,150 cannabis farmers into the legal market, a relatively new form of cannabis business has emerged: a middleman that does not grow pot itself, but rather distributes it.

Flow Kana, one of the largest legitimate cannabis distributors in California, has built relationships with more than 100 farmers in the state’s Emerald Triangle — a region consisting of Humboldt, Mendocino and Trinity counties, renowned for their pot-growing prowess — and expected to finish 2018 with revenue of $27.5 million, according to information provided to prospective investors that MarketWatch obtained. Flow Kana is burning through cash fast, though, with 78% of its projected going to costs related to its plan to become one of the country’s largest weed businesses: The company expects revenue to balloon to $2.26 billion by 2022, and profitability to arrive in 2020.

Success as a distributor is far from a sure bet in the U.S., where operating a marijuana company is illegal under federal law and brings a host of challenges. Like their counterparts in Canada, many emerging U.S. operators seek vertical integration, where a retailer grows pot that it sells as brands its own stores.

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It’s unlikely that vertically integrated cannabis companies will survive in the U.S. in the long run if every other mature sector is any indication, PI Financial analyst Jason Zandberg said. There is little to no advantage to such a business, he said, and most marijuana companies in the U.S. and Canada are only doing so because they are forced to by regulations.

“It’s more efficient to have all of the participants in the market specialize in retail, cultivation and so on,” he said.

Growing pot is also a massive challenge that will eventually see tight margins and require enormous scale to make money doing it. “Look at greenhouse tomato or pepper growers, the margins are thin there, and they make money at scale,” Zandberg pointed out.

In Canada, some public companies, such as Cronos Group Inc. CRON, +4.67% , CRON, +4.80% which has taken a $1.8 billion investment from Marlboro-maker Altria Group Inc. MO, +0.08% , have told MarketWatch in the past that they regard cannabis cultivation as a necessary evil in the short term. Canadian-licensed producers have made massive bets on growing their own pot despite any doubts about long-term plans, though, as legalization of recreational marijuana has opened up their avenue to sell to the public.

Canopy Growth Inc. CGC, +1.86%WEED, +1.93% has funded 5.6 million square feet of capacity across the country and shows little sign of slowing. Rival Aurora Cannabis Inc. ACB, +7.41%ACB, +7.49% has also made a big bet on a huge growing footprint, funding 4.7 million square feet for eventual cultivation and sale. Even Cronos has spent significantly on cannabis cultivation capacity, funding 1.3 million square feet in facilities across the world. In its documents, Flow Kana did not disclose the sum total of the growing space its farmers have.

Flow Kana co-founder and Chief Executive Michael Steinmetz said that in its early days, the company was focused on building a brand by packing cannabis in clear glass jars and charging premium rates, even holding a series of cannabis tasting events in the San Francisco Bay Area to market the new company. The events were some of the first of their kind and included the cannabis farmers themselves, who talked about their products and the farms on which they were grown.

Steinmetz had — and has — big plans, saying then he wanted to expand the business across the country.

“From our perspective, our mission was always building a supply chain for our growers,” Steinmetz said in an interview at Flow Kana’s Redwood Valley headquarters in December. “And originally, three or four years ago when we launched the company, I envisioned this evolving into a consumer-product industry before there were brands and dispensaries, but we got laughed at.”

Steinmetz said he and his wife went to roughly 23 pot shops around the Bay Area and couldn’t sell the glass jars containing cannabis, saying that retailers didn’t understand what they were buying because they were so used to buying pot by the pound and packaging it in small bags. So, out of necessity, Flow Kana created a direct-to-consumer sales operation via a web app and delivery drivers in order to bypass retail altogether.

“It was validating the idea that people care about branded product,” Steinmetz said. “People care about the story and the narrative and they cared about the organic, small farmer who is sustainable. And once we proved that, then we raised the capital to backdoor into the distribution.”

Steinmetz would like to make organic pot a big part of the brand, but pot growers cannot obtain organic certification from the U.S. Agriculture Department because marijuana is prohibited federally in the U.S., making it likely that its marketing department will have to dream up another way of saying the same thing. It also means that Flow Kana, like every marijuana company, struggles to use banking services and violates federal criminal conspiracy statutes and drug-trafficking laws.

Flow Kana ultimately closed its delivery business in 2018 and today, Steinmetz runs one of the most powerful distributors of cannabis grown in the Emerald Triangle, talking about Flow Kana as a business akin to Sunkist Growers Inc., the orange and citrus cooperative.

“Think of our business as: We don’t cultivate, we partner with master farmers, legacy farmers that have been doing it for generations, and that’s been our mission from day one,” Steinmetz said. “But what we bring is basically scale and capital and resources and everything that happens post-harvest. We sit right in the middle of the supply chain. We don’t cultivate, we don’t do retail. We basically process, package and distribute.”

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To that end, Flow Kana hired former Sunkist Chief Operations Officer John Striff in 2018 and has reshaped the business to look more like that operation, which, according to the documents, it has accomplished to some extent within California. Part of growing the company meant building a technology platform and software for farmers, which Flow Kana uses to help manage various details of distribution.

“It’s an interesting model, definitely it works when there’s a robust industry, when there are a lot of producers, and a lot of people you can choose to buy from,” Robes Cannabis co-founder and CEO Maxim Zavet said in a telephone interview. Zavet was the top boss of Emblem Corp. EMMBF, +0.51%EMC, +0.00% and took the company public in Canada. Where Zavet said Flow Kana’s strategy falls apart — or is at least considerably more challenging — is in Canada, where the presence of provincially run distributors make it much more difficult for a middleman such as Flow Kana to operate at national scale.

Cannabis ready to be processed at Flow Kana headquarters.

Where Flow Kana does operate in California, the state had a messy first year of recreational adult use. Complex and changing regulations throughout 2018 hampered sales and city bans have made cannabis difficult to obtain legally. Tax revenue has disappointed lawmakers and slow-to-start sales cut deeply into Flow Kana’s top line for the year: In February, revenue was less than $500,000, but skyrocketed to more than $1 million in July and $2 million in August, after changes to lab testing requirement took effect, according to the documents obtained by MarketWatch.

Booming sales in July and August are a good sign for a weed business, according to Zandberg. In a telephone interview, he said that few cannabis companies were prepared to do business on July 1, when the new testing requirements took effect. That Flow Kana sold as much pot as it did suggests that it had many aspects of its operation figured out under the complex legal regime.

Like many startups, Flow Kana is bleeding red ink. According to its internal projections, the company is set to lose roughly $1.5 million a month for an annual operating loss of $18.2 million; it estimates 2018 after-tax recurring cash losses of $21.4 million. The losses may be why Flow Kana is completing a new round of funding as of publication time. The documents say Flow Kana plans to use the cash infusion to acquire additional trim facilities, distribution hubs and acquire stakes in other pot businesses that fit with the company’s mission. Before this year’s fundraising effort, the company had banked $50 million from investors including Elevation Partners’ Roger McNamee, who was an early investor in Facebook Inc. FB, -0.28% , and Gotham Green Partners, which also invested in Cronos.

Flow Kana headquarters in Mendocino County, Calif.

Mackie Research analyst Greg McLeish said that he expects cannabis to become a commodity crop in the long run, especially the marijuana grown in greenhouses or outdoors. And in more mature cannabis markets, consumers tend to move away from dried flower or pre-rolled joints into concentrates, such as vaporizer products and edibles.

“Once you do that, you’re making a product from something that you’re extracting, and the initial input doesn’t necessarily have to be the superpremium, high-quality bud,” McLeish said over the phone.

According to the documents obtained by MarketWatch, Flow Kana plans to start selling vapes, bulk oil and other products this year. Of the $2.26 billion it is projecting to make in 2022, $1.12 billion would be from vape sales, up from the $35 million it is projecting for 2019.